Lessons from the Great Galactic Depression

A long time ago, in a galaxy far far away, there were two planets orbiting a star, not unlike our own sun.  The inhabitants of these planets share a common ancestry but, over the years, they have developed somewhat different temperaments. 

The names of these planets are difficult to pronounce in English, but we will call them Nordus and Sudus. The name of their star is Sol. Nordus, being further away from Sol, has a colder climate than Sudus and its inhabitants are known to be frugal and patient. The Sudusians, in contrast, live for the moment.  Using the language of economics, earth people would say that the Sudusians have a higher rate of time preference. 

For many centuries, the Nordusians and the Sudusians were often at war. But in recent years, the development of a new and dangerous weapon, the Death Star, has made war infinitely more risky. Some fifty Sols ago, the political elites of the Solarian system, realizing the danger of mutual destruction, entered into an economic and monetary union.  At the inception of the union, each planet abandoned its own monetary unit and a new Solarian Central Bank (SCB) was created; its President is a wise Solarian by the name of Obi-Mar Draghobi. Under Obi-Mar's guidance, the SCB issued a new currency, the Solo, which takes the form of little pieces of colored plastic called Solarian credits, or screds.

The Solarian social structure is composed of dynastic families who accumulate wealth and pass it down to their children. This system is fairly stable but dynasties do not last forever. Sometimes, a Solarian family produces a "bad wookie"  who squanders the family fortune. And often children quarrel with their parents and are disinherited. As a consequence, there is constant regeneration of dynasties and a dynastic wealth distribution that depends on dynastic age and dynastic time preference. The governments of Nordus and Sudus sometimes engage in infrastructure projects that benefit not only current generations of Solarian citizens, but also generations yet to come. A good example is the investment by the Nordusians in Warp drive technology to enhance trade with neighboring star systems. 

Solarian economists are an advanced lot who agree about most things; the Solarians call them “dentists". When the Nordusian government embarked upon the Warp program, it consulted with the Solarian Association of Dentists (SAD) who recommended that Warp investment be funded not just from current taxes, but also from Nordusian government bonds. Since the benefits of the Warp drive are very long-lived, the initial investment was paid for by issuing 3% consols. These are scred-denominated claims to a flow of 3% of the principal in perpetuity. The Sudusian government, like its Nordusian neighbors, also issues consols. But the profligacy of the Sudusians is legendary and the citizens of Solaria, both Nordusians and Sudusians, are unwilling to buy Sudusian consols at 3%. Instead, they require a 2% default premium to reflect the considerable possibility that a future Sudusian government may decide to default on its debt. Since much of the debt has been used to finance transfers to Sudusian pensioners, and, some say, star cruisers for the Sudusian political classes, the probability of default is only too real.

On  setting up the Solarian Central Bank, SAD dentists were once again consulted. They pointed out that screds are costless to produce and they have value solely because of their use in exchange. Because scred creation is costless, the SCB, as the monopoly provider of screds, can create wealth. But how is that wealth to be distributed? The founders of the Solarian union were far sighted and wise. They created a rule that distributes the benefits of scred creation back to the citizens of Nordus and Sudus in proportion to the number of citizens of each planet. Since there are approximately equal numbers of people on each planet, in practice, the Nordusian and Sudusian peoples receive equal shares of seigniorage revenues created by the SCB.

These revenues are of three kinds.  First, there was the creation of sc1 trillion at the inception of the union. Second, there is the ongoing flow from the creation of new screds to meet the need for liquidity as the Solarian economy grows. And third, there is the flow of revenues generated by the interest payments on the asset holdings of the SCB. At its inception, the SCB needed a way to introduce screds into circulation. Following a recommendation by the Solarian Dental Council, the SCB purchased sc1 trillion of consols split equally between Nordusian and Sudusian bonds. And every twelfthsol, the SCB purchases a further basket of consols, equally weighted, between Nordus and Sudus. The exact amount purchased depends on economic conditions in the Galactic Empire; but there has not been a single twelfthsol since the inception of the SCB, when the Bank did not purchase at least some consols in the financial markets.

The Nordusian government pays 3% interest every Sol to the SCB and, under its charter of incorporation, the SCB turns around and pays those revenues right back to the Nordusian Treasury. Similarly, the Sudusian government pays 5% (3% plus the default premium) every Sol to the SCB which the SCB returns to the Sudusian Treasury.  The situation I have described worked like a charm for more than fifty Sols, from the inception of the union in Sol MMCX through to the onset of the Great Solarian Depression in Sol MMCLX. The history of this episode is well known so I will be brief. 

During the Protracted Expansion that lasted for almost twenty five Sols, the Nordusian banks invested heavily in foreign bonds issued to fund res-pod construction at the Galactic Center. As pod prices escalated there was an unsustainable wave of new pod development that ended in disaster with the bankruptcy of the Jabba Brothers bank in Sol MMCLII. As we all know, the collapse of Jabba Brothers caused the entire galactic economy to spiral into a deep depression. The Galactic Depression had profound effects for the Solarian economy and the Sudusian government defaulted on its debt. Much of this debt had been held by Nordusian banks. Although the default caused consternation for Nordusian shareholders, the Solarian Association of Dentists pointed out, correctly in my view, that the Nordusians should not have been too surprised. They had, after all, been earning a premium of 2% on their investments in Sudusian bonds for more than ten Sols. 

Some Sudusian dentists reminded the Nordusians that, after all, they had themselves defaulted on bonds issued to fund the last Galactic War and as one charismatic Sudusian Politician put it; "what's sauce for the hoska is sauce for the hosko". And of course, Obi-Mar Draghobi's masterful handling of SCB affairs is by now the stuff of vidtexts. His successful negotiation with the Nordusian Chancellor, and former Princess, Queen Anga-Leia over the funding of future scred creation is widely credited with saving the Solarian union and heading off another Galactic war.  The Nordusians argued that, since the Sudusians had defaulted on their debt, the SCB should be banned from future purchases of Sudusian consols. Obi-Mar Draghobi pointed out, that the financial markets had long since capitalized the default probability of existing bonds and that nobody should be surprised when the inevitable finally happened. Excluding Sudus from the benefits of future scred creation, that was by then running at approximately sc60 billion a twelthsol, would be an unfair penalty to Sudusian taxpayers and could easily kindle a resurgence of the rebel alliance.

Initially, Queen Anga-Leia listened to her finance minister Darth Scheudius, who argued that the Sudusian default had put the Nordusian taxpayer on the hook and the Sudusian's should be made to repay the full amount. Obi-Mar Draghobi pointed out that the purchase of Sudusian consols was a once and for all transfer and that the debt to the SCB was never expected to be repaid.  The rest as they say, is history. The Sudusian Treasury re-entered the capital markets after a short delay and a considerable shakeup of its political elite. It is to be hoped that the new Sudusian finance minister, Hanis Soloufakis, will manage to pull off the considerable reforms that will be required if the union is to survive a potential future Galactic crisis.

Why the ECB Should Take More Risks

Mrs. Merkel and Mr. Schäuble are worried. The ECB is planning to buy the sovereign debt of its member states and Mr. Schäuble doesn't trust his southern European partners. He thinks that Portuguese, Spanish and Italian debt is risky and he knows that Greek debt is.

Bankers are supposed to be boring. And central bankers are supposed to be boring in spades. What would happen if the Fed were to bet the farm, buying shares in an internet start-up that subsequently goes bust? The public purse would be on the hook for the loss. At least, that’s the theory. That theory is wrong.

The central banking business plan is a money-spinner beyond a venture capitalist’s wildest dream. Buy an asset, any asset, and pay for it by issuing little pieces of colored paper. Collect the interest payments and dividends from the assets and use them to pay for your house, your car and a holiday in Spain. If you happen to be the central bank of a sovereign state, pay the interest and dividends to the treasury to help reduce the tax bill of your citizens.

Does it matter which assets you buy? Conventional wisdom says yes. A central bank should buy safe assets, typically promises issued by its own national government that will never fall in value. The Fed buys T-bills on the private market. The Treasury pays the interest and principal to the Fed, and the Fed turns around and pays them straight back to the Treasury. The point of all of this is to keep enough of the little pieces of colored paper passing from one person to another to “oil the wheels of trade”.

What if the Federal Open Market Committee were to put all of the Fed’s assets into the stock market the day before a stock market crash? If the Fed were privately owned, it would be put into receivership. After the crash, it has liabilities of $2,500b. These are the circulating pieces of colored paper. But its asset portfolio has been decimated by the market crash and the market value of those shares has fallen from $2,500b to $1,000b. What a calamity! Surely the taxpayer must rush in and recapitalize the Bank by pumping in another $1,500b. Not so.

Central banks, like the rich, "are different from you and me". Their debts are all in the form of those little pieces of colored paper. And the magic of central banking is that you and I will carry on passing those pieces of paper from one to another without ever trying to cash them in for something else. There was a time when the UK government printed the promise to “pay the bearer on demand, the sum of one pound” on its notes; at the time, a pound note was redeemable in gold. That time is long gone. All you will get at the Bank of England now, if you try to redeem your ten pound note, is two fives.

What does all of this have to do with the ECB? Mrs. Merkel and Mr. Schäuble should sleep easily in their beds. The interest payments on ECB assets are returned to national governments in proportion to a formula that weights each country by its relative size. As Paul DeGrauwe pointed out recently in a VoxEU post, as long as the ECB sticks to this formula when it buys sovereign debt, the only people to suffer from an Italian default will be private holders of Italian bonds. The net worth of the ECB may take a temporary hit, but that shouldn't bother European taxpayers, least of all the Germans.

Extraordinary times require extraordinary measures. There was a time when central banks were privately owned. The Swiss National Bank still is. But the Bank of England, the Federal Reserve and the European Central Bank are supra-national institutions that play by different rules. We should not be concerned if sovereign states are permanently in debt. This has been the case with the UK and the US treasuries for as long as the US and the UK have existed as sovereign nations. What is true for a national treasury, is also true for a central bank.

Secular stagnation: a neo-paleo-Keynesian perspective

I first posted this piece back in January but it got deleted by from my blog by mistake. Since secular stagnation is back in the blogosphere with a vengeance: its time to repost it.

In a recent piece on his blog, David Beckworth has taken another swing at the secular stagnation hypothesis. Secular stagnation is a term coined by Alvin Hansen in a 1938 article in which he claimed that public expenditure might be required to maintain full employment.

Here is Alvin, as quoted by David...

"The business cycle was par excellence the problem of the nineteenth century. But the main problem of our times, and particularly in the United States, is the problem of full employment. ... This is the essence of secular stagnation— sick recoveries which die in their infancy and depressions which feed on themselves and leave a hard and seemingly immovable core of unemployment."

Hansen is writing in 1938, before Keynesian economics had been forever altered by Samuelson's bastardization of Keynes' key idea: that high involuntary unemployment is an equilibrium that can persist for decades. 

The secular stagnation hypothesis was resuscitated by Larry Summers.  In Larry's view

... it is increasingly clear that the trend in growth can be adversely affected over the longer term by what happens in the business cycle.

Larry supports his position with the following graph.

Figure 1: Downward Revision of Potential GDP

Growth is the percentage annual increase in real GDP.  In terms of Figure 1, it is measured by the slope of the lines that represent estimates of potential GDP made in 2007 (the dark grey line) and in 2013, (the light grey line). Try as I may, I do not see compelling evidence of a change in the slope. 

What I do see in Figure 1, is evidence that a business cycle shock (the Great Recession) has caused a permanent downward shift in the level of GDP. And that is tragic because if Alvin Hansen is right, and I think he is, the gap between these two lines represents an annual loss of output of approximately one trillion dollars.  

Contemporary accounts of secular stagnation, beginning with Larry Summers, confound two distinct ideas. The first, and this is Hansen’s meaning, is that a market economy, in the absence of counter-cyclical fiscal and monetary policies, may experience prolonged periods of high involuntary unemployment. The second,  is that a market economy may experience a period of depressed productivity growth.

David is critical of the second of these two ideas. Here is David...

"Hansen’s article was of course spectacularly wrong as a guide to the next few decades. Instead of suffering through stagnation we entered an extended, broad-based, and massive economic boom. In hindsight we can see that his analysis, ... was unduly influenced by the depression he was living through, ... [which] was the result of specific policy mistakes rather than inexorable trends. Recent research by Alexander J. Field shows that the 1930s were actually a time of exceptionally high productivity growth. " 

David claims that postwar productivity  growth was high. That may be true. But it says nothing about secular stagnation, which is the idea that there has been a permanent long-term increase in involuntary unemployment. Back to David:

"The fact that Hansen was wrong does not prove that contemporary stagnationists are. In this case, though, history is repeating itself rather exactly. We do not pretend to know what the future path of economic growth in the United States will be. But the case for stagnation is weak—and, as in the 1930s, it is getting undue credence because of a long slump caused by policy mistakes."

Not so. David is confounding growth, the annual percentage increase in real GDP per person, with unemployment, the percentage of workers who claim to be looking for a job but are unable to find one. Growth remains a topic on which, as economists, we are spectacularly ignorant despite the fact that there is a large subset of  macroeconomists who have  studied very little else for the past thirty years. Unemployment, is a topic on which we have made considerable progress.

Were there policy mistakes?  Most certainly.  Would a more effective way of running monetary policy be to replace inflation targeting with a nominal GDP target as the market monetarists have claimed? I am skeptical.  

It is a premise of the monetarist position, that the real economy is self-stabilizing and that a rule based monetary policy is the most effective way to ensure both low inflation and maximum sustainable employment. 

Keynes claimed, in contrast, that the real economy can get stuck in a position of high unemployment and that permanent high involuntary unemployment can persist as an equilibrium phenomenon. See my earlier post on the neo-paleo-keynesian perspective. If Keynes is correct, and I believe he is, a single instrument, monetary policy, is not enough to hit two targets. Fiscal policy in one form or another, is an important second string to the policy maker's bow.

The Greek dance with debt

If you thought that the Greek debt crisis was over; think again. Tomorrow, the Greek parliament will try, for the third time, to agree on who will be the next president. If parliamentarians cannot agree (and that now seems likely) we are headed for the first potential rock in the road to recovery for 2015.  There is a real danger that the Greek debt crisis will emerge with a vengeance and, once again, throw world financial markets into turmoil.

Under the rules of the Greek constitution, if no candidate receives an absolute majority, parliament will be dissolved, and there will be a general election, most likely in early February. If that happens, all signs point to a victory by Syriza, a left of center party that proposes to renegotiate the Greek debt.

A Syriza victory would force the core Euro countries to decide either to give up on the project of European integration, or to move to the next stage of full scale fiscal union in which German taxpayers assume responsibility for Greek debt.

If the Euro breaks apart, the fallout will be global. The world economy has been hit by a falling demand for raw materials and oil is trading at less than US$60 a barrel. Some of this is caused by newly discovered proven reserves and that is a good thing. But Jim Hamilton has argued that  falling world demand is a big part of the reason for lower oil prices and that does not bode well for a truly global recovery.

The US economy has been the single flickering light in a dark sky. If the Euro collapses, the knock-on-effect will derail the US recovery and send the entire world economy back into recession.

Is a Greek default and a breakup of the Euro the most likely outcome? Probably not. But it is the first of many building storms that the global economy will need to weather in 2015. All eyes on Greece tomorrow!

Real business cycle theory and the high school Olympics

I have lost count of the number of times I have heard students and faculty repeat the idea in seminars, that “all models are wrong”. This aphorism, attributed to George Box,  is the battle cry  of the Minnesota calibrator, a breed of macroeconomist, inspired by Ed Prescott, one of the most important and influential economists of the last century.

All models are wrong... all models are wrong...

Of course all models are wrong. That is trivially true: it is the definition of a model. But the cry  has been used for three decades to poke fun at attempts to use serious econometric methods to analyze time series data. Time series methods were inconvenient to the nascent Real Business Cycle Program that Ed pioneered because the models that he favored were, and still are, overwhelmingly rejected by the facts. That is inconvenient.

Ed’s response was pure genius. If the model and the data are in conflict, the data must be wrong. Time series econometrics, according to Ed, was crushing the acorn before it had time to grow into a tree. His response was not only to reformulate the theory, but also to reformulate the way in which that theory was to be judged. In a puff of calibrator’s smoke, the history of time series econometrics was relegated to the dustbin of history to take its place alongside alchemy, the ether, and the theory of phlogiston.

How did Ed achieve this remarkable feat of prestidigitation? First, he argued that we should focus on a small subset of the properties of the data. Since the work of Ragnar Frisch, economists have recognized that economic time series can be modeled as linear difference equations, hit by random shocks. These time series move together in different ways at different frequencies.

For example, consumption, investment and GDP are all growing over time. The low frequency movement in these series is called the trend. Ed argued that the trends  in time series are a nuisance if we are interested in understanding business cycles and he proposed to remove them with a filter. Roughly speaking, he plotted a smooth curve through each individual series and subtracted the wiggles from the trend. Importantly, Ed’s approach removes a different trend from each series and the trends are discarded when evaluating the success of the theory.

After removing trends, Ed was left with the wiggles. He proposed that we should evaluate our economic theories of business cycles by how well they explain co-movements among the wiggles. When his theory failed to clear the 8ft hurdle of the Olympic high jump, he lowered the bar to 5ft and persuaded us all that leaping over this high school bar was a success.

Keynesians protested. But they did not protest loudly enough and ultimately it became common, even among serious econometricians, to filter their data with the eponymous Hodrick Prescott filter.

Ed’s argument was that business cycles are all about the co-movements that occur among employment, GDP, consumption and investment at frequencies of 4 to 8 years. These movements describe deviations of  a market economy from its natural rate of unemployment that, according to Ed, are caused by the substitution of labor effort of households between times of plenty and times of famine. A recession, according to this theory, is what Modigliani famously referred to as a ‘sudden attack of contagious laziness’.

The Keynesians disagreed. They argued that whatever causes a recession, low employment  persists because of ‘frictions’ that prevent wages and prices from adjusting to their correct levels. The Keynesian view was guided by Samuelson’s neoclassical synthesis which accepted the idea that business cycles are fluctuations around a unique classical steady state.

By accepting the neo-classical synthesis, Keynesian economists had agreed to play by real business cycle rules. They both accepted that the economy is a self-stabilizing system that, left to itself, would gravitate back to the unique natural rate of unemployment. And for this reason, the Keynesians agreed to play by Ed’s rules. They filtered the data and set the bar at the high school level.

Keynesian economics is not about the wiggles. It is about permanent long-run shifts in the equilibrium unemployment rate caused by changes in the animal spirits of participants in the asset markets. By filtering the data, we remove the possibility of evaluating a model which predicts that shifts in aggregate demand cause permanent shifts in unemployment. We have given up the game before it starts by allowing the other side to shift the goal posts.

We don't have to play by Ed's rules. We can use the methods developed by Rob Engle and Clive Granger as Giovanni Nicolò and I have done here. Once we allow aggregate demand to influence permanently the unemployment rate, the data do not look kindly on either real business cycle models or on the new-Keynesian approach. It's time to get serious about macroeconomic science and put back the Olympic bar.